Fighting Fires

America’s midterm elections, Italy’s Five Star Movement and Brexit have the potential to amplify geopolitical risks in the year ahead. Have investors become too complacent about their potential impact on markets, asks Mellon Capital’s Sinead Colton?

With yet more political uncertainty looming in 2018 the big question is whether financial markets can continue to ignore political risk.

In the past year, the reactions to geopolitical challenges, from tense elections in the Netherlands and France to sabre-rattling between the US and North Korea, have tended to be sharp but short-lived.

Investors, it seems, have been prepared to look beyond the politics and focus instead on improving economic fundamentals. The upward march of global stock markets has carried on regardless as investors have largely shrugged off the potential threats, taking risks that two or three years ago they would have been unwilling to take.

We believe this has encouraged a dangerous sense of complacency that cannot last. Over the short-term, it is understandable for investors to trade on upbeat economic data and put aside political turmoil. However, the potential for geopolitical threats to cause economic harm means political risk will reassert itself over the longer-term. Investors who have become blind to geopolitical threats could be in for a rude awakening.

Where’s the volatility?

In a world of heightened political risk, volatility has been subdued, reflecting the belief stocks will continue to rise, regardless of geopolitical threats. The CBOE Volatility (Vix) Index, which is an estimate of the expected volatility of the S&P 500 over the next 30 days, spent most of 2017 sharply lower than its historical average of around 20.1 Could we witness similarly low levels of expected volatility in 2018?

In one sense, the low level of both realised and expected volatility is not surprising, given how well the equity markets have performed and where we are in the economic cycle. Macroeconomic data has not been that exciting but it has consistently indicated continued moderate expansion and subdued inflation in most developed markets.

Volatility has also been dampened by the growth of passive funds, which trade market indices and funnel investors into many of the same companies. Regulations introduced following the financial crisis have had a similar effect.

The Volcker Rule in the US has led to a sharp cut in the inventories of stocks held by Wall Street dealers. In combination with other regulations, such as the Basel III capital requirements and European Union solvency rules, this has reduced trading volumes and with it volatility, not just on the S&P 500 but across capital markets.

We now have a situation in the US where the pricing of risk is near historic lows, while the pricing of the stock market is at historic highs. As an illustration, over the past five years, the realised Sharpe ratio (return less cash divided by realised risk) of global equities is 1.1, compared with the long run expectations of 0.2-0.3. Against a backdrop of significant risk events we think this is not an environment that any investor should feel particularly comfortable with; volatility is artificially low and will, at some point, revert to more normal levels.

With that in mind, what political risks should investors look out for over the next 12 to 18 months?

Midterm elections

In November 2018, midterm elections will be held in the US and the result will be crucial for the Trump administration’s ability to pass legislation after that point.

In the Senate, 33 seats are being contested, while in the House all 435 seats will be up for re-election. A gain of 24 seats in the midterms would give Democrats control of the House. Even smaller gains could put roadblocks in the way of President Trump’s legislative agenda from the end of 2018.2

However, the midterms could also have a beneficial effect on markets before the vote happens. Their approach could galvanise the Trump administration to try and push through as much legislation as possible beforehand, particularly regarding infrastructure spending and tax reform.

The Trump administration has already moved a step closer to implementing a range of tax cuts after a budget deal was struck in the Senate. The deal makes it possible for a tax reform bill that adds US$1.5 trillion over a decade to the budget deficit.

Any corporate tax cuts would be positive for both US economic growth and stocks, instantly feeding through to earnings estimates and prospective earnings multiples. Until we have the final details it is impossible to know how different market sectors will be affected. However, domestically-focused smaller companies typically pay higher taxes and so are likely to benefit more from such measures than larger companies.

The package also includes a form of repatriation tax holiday for US multinationals. The current proposal is to tax intangible income overseas at a lower rate, and creates a path for companies to bring their intellectual property back to the US – in effect a lower corporate tax rate for intellectual property in the US. The last such tax holiday, the Homeland Investment Act of 2004, was introduced so that money bought back into the US could be used for investment and to increase employment.

In practice that does not appear to have happened. Studies suggest repatriations did not lead to an increase in domestic investment, employment or R&D. Instead the money was primarily used to boost payouts to shareholders and increase executive compensation.3 Therefore, the effect of another tax holiday on the economy will depend on how repatriated foreign earnings are spent.

Cuts to personal tax rates are likely to have a more predictable outcome. Sluggish wage growth has been a consistent feature of the US recovery since the financial crisis. US stocks across the board would be expected to benefit from what would effectively be a pay rise for millions, assuming the impact is not offset by the removal of state and local tax deductions. Personal tax cuts would be positive for US growth, a significant support for the dollar and could also push Treasury yields higher.

Populist backlash

Looking to Europe, there may be an impression the continent has turned a corner. European elections in 2017 did not result in the potentially destabilising upsets feared following the Brexit vote in 2016. In the Netherlands and France anti-EU populists were defeated. In Germany Angela Merkel returned to power, albeit in a weakened position.

However, the populist Five Star Movement still poses a risk when Italians go to the polls; an Italian general election has to take place by May 2018. Given the Italian economy has barely grown since the financial crisis, economic disillusionment and anger towards the financial sector could result in significant gains for the anti-establishment party. This could reignite problems for the eurozone and European Union (EU). Luigi Di Maio, Five Star’s candidate for the premiership, has called for a referendum on Italy’s euro membership as “a last resort” to force EU reform.4

Nor is the Italian election the only potential threat to Europe’s stability in 2018. The constitutional crisis in Spain caused by 2017’s ‘illegitimate’ Catalan independence vote is likely to bubble on for some time. A Catalonian secession could lead to similar independence demands in other regions of Europe such as the Basque country and Lombardy and Veneto in Northern Italy. Given how destabilising such an outcome would be, prolonged negotiations seem more likely than the break-up of Spain. However, it is still one to watch as a stable outcome cannot be guaranteed.

It will also be necessary to keep an eye on the Brexit negotiations. Although progress in the negotiations is likely to be slow, as the UK gets closer to exiting the EU, its potential impact on UK economic growth will become clearer. Meanwhile, higher inflation - primarily driven by the weakness of sterling following the EU vote - and low wage growth is already a cause for concern.

Prepare for the unexpected

Of course, the nature of political risk means there will always be unexpected events which emerge from left field that can have a potentially unsettling impact on asset prices.

Whatever these risks, they will emerge at a time when several developed market central banks are moving to unwind accommodative monetary policy. The impact on markets of this great reversal is difficult to forecast; the quantitative easing policies enacted in the aftermath of the financial crisis have been arguably the largest central bank experiment in history.

Here again, one of the biggest dangers is complacency. Central bank tapering and balance sheet reduction have been discussed for so long that investors may have become somewhat blasé about the potential for them to cause market disruption. If such disruption coincides with another significant geopolitical risk event any complacency could be severely punished.

What to watch in 2018

Reactions to geopolitical risks

US midterm elections in the US

Catalan separatism; Italian elections

1. Business Insider: ‘The VIX is flirting with its lowest close on record’, 25 July 2017.2. CNBC:‘ Despite Trump's low ratings, midterm election map still favors Republicans — for now’, 8 August 2017.3. Dharmapala, Foley, Forbes:‘ Watch What I Do, Not What I Say: The Unintended Consequences of the Homeland Investment Act’, April 2010. 4. Bloomberg:‘ Political Risk Makes a Comeback in Europe’, 2 October 2017.

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For 30 years Mellon Capital has been widely recognized as a pioneer in applying modern portfolio and capital market theory to the investment process. They offer global multi-asset solutions and strategies ranging from indexing to alternatives.